Compound interest

Compound interest arises when interest is added to the principal, so that, from that moment on, the interest that has been added also earns interest. This addition of interest to the principal is called compounding. A bank account, for example, may have its interest compounded every year: in this case, an account with $1000 initial principal and 20% interest per year would have a balance of $1200 at the end of the first year, $1440 at the end of the second year, and so on.

Compound interest grows the principal geometrically, instead of arithmetically. It has been variously referred to as “the most powerful force in the universe”. Hyperbole aside, compound interest growth picks up steam over time with the later phases of growth occurring faster and bigger.

In finance and investing, compound interest is one of the most important principles of good financial management. For example, investors are often told to reinvest dividends in the stock that paid it. This way, the income gets reinvested and will earn future dividends, that will keep on multiplying. This is an example of compound interest being applied to stock investments.

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